CEOs Don’t Care Enough About Capital Allocation

In his 1987 letter to investors, Warren Buffet made the following observation: “the heads of many companies are not skilled in capital allocation, and … it is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.”

A quarter century later, not much seems to have changed: fewer than five out of the 100 CEOs on HBR’s 2014 list of best-performing CEOs even mention “return on capital” on their official biography — and none of those five lead companies listed in the Dow Jones Industrial Average (DJIA) or in the EuroStoxx50.

This failure to even mention return on capital seems perverse. It’s been more than 50 years since Nobel prizewinners Franco Modigliani and Merton Miller identified return on investments as a major component of value creation (and value destruction). It is, in fact, the salt in the value recipe. Unless your company’s return on capital exceeds its cost of capital, no amount of revenue growth can create value.

For the many firms whose cost of capital and return on capital are roughly equal, in fact, the only path to value creation is to increase return on capital. The results can be impressive: if your firm’s return on invested capital is 8% and you have an 8% cost of capital, a 1% improvement in ROIC will increase firm value by 19%. And at a time when growth opportunities are limited, it is arguably the only way to create value.

There are just two ways to increase ROIC: improve operating profit (by increasing revenues or cutting costs) or invest capital more wisely. The revenue and cost path is, however, well trodden in a low-growth economy and evidence suggests that the real leverage comes from making smarter investment decisions.

A 2012 McKinsey Report shows that over a 15 year period companies that shifted more than 56% of their capital across their business units during that period delivered annual return to shareholders that were a third higher than those delivered by companies that allocated roughly the same amount of capital per unit as they had the previous year. The results are shown in exhibit 1. Another study by private equity investor William Thorndike shows that this aggressive group outperformed the S&P 500 by over twenty times.

This, of course, raises an obvious question: Why are so few CEOs skilled at capital allocation?

Looking at the resumes of current CEOs across developed markets suggests that the answer may be that many lack training in the skills of investment analysis. As the chart below shows, only half of the CEOs of companies in the Dow Jones Index have previous experience in corporate finance or strategy. It’s worse in Europe, where the proportion falls to just 32% of CEOs of EuroStoxx50 companies.

Those of us in private equity (and our counterparts in active investment funds) are well aware of this skills gap. We know that we need a CEO for the management of current business operations in the companies we own, but we also know that we are generally better at allocating the excess cash generated from operations or from external fund providers. The generally superior returns that the top private equity funds deliver are almost entirely explained by their decisions on what to do with the investment capital available to the firms they own.

The bottom line? Boards that are serious about value creation need to look more carefully at the track records of the CEO candidates they’re recruiting. They might even think about recruiting executives with some experience in private equity — which few CEOs of companies in the Dow Jones Index or the EuroStoxx 50 can claim to have.

José Antonio Marco-Izquierdo is a partner at Magnum Industrial Partners, a private equity firm focusing on investments in Spain and Portugal.